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To: Hawkmoon who wrote (35)	1/19/2001 11:54:27 AM
From: Hawkmoon	Read Replies (1) \| Respond to of 312

January 16, 2001 California and Arizona: Contrasting Approaches to Electric Power Competition The continuing energy and utility financial crisis in California naturally raises questions about the potential for similar developments in Arizona and for spillover effects on Pinnacle West and its subsidiaries and customers. Our customers should recognize the stark contrasts between the Arizona approach to competition and California’s and be assured that our goal is to avoid a similar situation here. However, the California situation may continue to be very volatile and to affect prices throughout the West. Under those circumstances, if we have an extended problem with a major generating unit or transmission line, we could have significant exposure to high energy prices. When California embarked on its competitive adventure, lawmakers and utilities assumed that wholesale power prices would go lower. Now, that market structure has failed. Two of the utilities are nearly bankrupt, and the third is compiling another huge “stranded cost” with no current plan for resolving it. The Financial Effect To date, the major effects of the California crisis on Arizona are high spot market and futures prices for power. However, through some prudent hedging (buying the right to buy power at a fixed price) last winter and spring, we avoided much of the impact from the high spot market prices. In California, wholesale market prices for power have increased dramatically. Other areas in the U.S. have experienced brief price spikes, but nothing as sustained as California. Southern California Edison (SCE) and Pacific Gas & Electric (PG&E) are forced to buy power at high wholesale prices but cannot pass those prices along to their customers because of a retail price freeze. Those two utilities have accumulated huge debts and are threatening bankruptcy. The third major California utility - San Diego Gas & Electric – ended its rate freeze early in 2000 and began passing the high wholesale prices on to its customers. Customers were outraged to find their power bills doubled, tripled, or even worse. Their protests led the state legislature to allow the utility to go back to the old regulated prices. Meanwhile the difference between the old regulated price and the high wholesale price is being accumulated and is supposed to be resolved at some point in the future. The Causes The California situation has a number of causes on which there is general agreement. These causes include higher power demand from a booming economy, unprecedented natural gas prices, transmission congestion or “bottlenecks,” a requirement for the utilities to buy all power from a Power Exchange without the ability to do forward price hedging, lack of new power station and transmission construction, and market structure inefficiencies. In addition, low rainfall in California and the Northwest recently has reduced the availability of hydroelectric resources. Some observers also feel that “price gouging” by generators has contributed to the crisis, although this is a controversial issue. A look at the major causes of the California situation shows that Arizona has avoided many of the major pitfalls affecting its neighboring state. Customer protections. California exposed customers in San Diego to market prices, at least for several months. Customers should not be exposed to real-time prices unless they have the ability to alter their usage patterns in response to high prices. For most residential customers and small businesses, this is an alien concept. Arizona protects its customers through 2004, with cost reductions allowing significant price decreases for APS customers. Market system. California created a complex, inefficient market structure. In addition to day-ahead and hour-ahead markets at the Power Exchange, the Independent System Operator (ISO) administers a complex series of spot markets for balancing power and ancillary services. This creates incentives for generators to withhold power in one market and sell it at a higher price in another market. Arizona has not imposed a wholesale market structure, but is allowing utilities to create a regional transmission organization. Spot market vs. forward contracts. California forced its utilities to buy all their power from an untested Power Exchange (a separate organization created to hold a daily power auction that matches buyers and sellers). They were generally not allowed to sign contracts for power well in advance of when the power would be needed. Arizona allows its utilities to buy from any source, to sign long-term forward contracts and to reduce their financial risk through hedging. This flexibility allows us to ensure reliable sources of power for our customers and limits our exposure to volatile spot markets. Resource planning. California avoided building new generation and transmission lines for many years, and construction of power stations came to a standstill as the economy grew during the 90s. As a result, it has a large power capacity deficit and must rely on imported power, which puts pressure on its inadequate transmission system. Arizona has adequate generation and transmission resources to meet its immediate needs except during periods of the highest demand this summer (2001). Current plans for new generation and transmission resources will continue to ensure adequate generation supply and prevent disruptive congestion on transmission lines. Transition speed. California began its transition to competition with a “big bang,” leaping into an untested market that was built by committee. Arizona is allowing an orderly transition to competition and is not imposing an untested market mechanism on the state’s utilities. Natural gas prices. California is and will continue to be vulnerable to fluctuations in natural gas prices because a high proportion of its power comes from this fuel. In fact, California has no coal plants and its nuclear capacity is not large given its huge electric consumption. Arizona has a more balanced energy mix, and even with planned combined cycle units the company will have a balanced mix of nuclear, coal and natural gas plants. Some actions are being taken to try to fix the California situation. Federal regulators ordered that the utilities should be allowed to purchase power under long-term contracts, which will enable the utilities to control their financial risk and may stabilize wholesale prices. California regulators raised electric rates, but the utilities’ opinions and Wall Street’s reactions are that the hike is inadequate to solve the financial crisis. State authorities also are trying to accelerate the approval process for building new power plants. The governor has threatened more drastic action such as exercising eminent domain to take over the state’s power plants. The Arizona Advantage In California there were long and complex arguments about how to build a competitive wholesale market that would benefit customers and attract new suppliers. Those arguments will continue, but we don’t have to resolve them here in Arizona right now. Our regulators have allowed a more reasonable timetable for the transition to competition. We have time to build new power stations to increase supply and new transmission lines to relieve potential bottlenecks. Over the next 10 years, the needs of our customers are expected to increase by as much as 1,500 megawatts. At the same time we plan to finish six generating units and five transmission lines to more than match that increased demand. In addition, other companies have proposed building about 12,000 megawatts of new capacity in Arizona. Finally, we have more than three years to learn from market experiences in California and other regions. When we get to the end of the restructuring period in 2004, we must go back to the Arizona Corporation Commission before we can change prices. This process will assess the status of workably competitive markets and determine the next steps toward competition through a consensual process. By then, wholesale power and natural gas markets may have stabilized because new power, transmission and natural gas resources should be available and improved market structures should be in place. aps.com